Principles of Economics
Lecture 1
Introduction to Economics
Tan Khay Boon
Email: khayboon@ntu.edu.sg
Topics
Hypothetical auction
Would you walk to town if someone paid you $9?
If you would walk to town for less than $10, you gain
from buying the item in town
Economic Surplus
The economic surplus of an action is equal
to its benefit minus its costs
Opportunity Cost
Opportunity cost is the value of what must
be foregone in order to undertake an activity
Consider explicit and implicit costs
Examples:
Give up an hour of babysitting to go to the
movies
Give up watching TV to walk to town
Sunk Cost
Sunk Costs are costs that are beyond
recovery when a decision is made
Irrelevant to future decision making
Only costs that influence a decision are
those that can be avoided by not taking
the decision
Only benefits that influence a decision are
those that would not occur unless the
action were taken.
Economic Models
Simplifying assumptions
Which aspects of the decision are absolutely
essential?
Which aspects are irrelevant?
Total Cost
($B)
Average Cost
($B/launch)
$0
$0
$3
$3
$3
$7
$3.5
$4
$12
$4
$5
$20
$5
$8
$32
$6.4
$12
Marginal Cost
($B)
Positive economic
principle predicts how
people will behave
The average price of
gasoline in May 2010
was higher than in
May 2009
Building a space base
on the moon will cost
more than the shuttle
program
Incentive Principle
Microeconomics and
Macroeconomics
Microeconomics studies
choice and its implications
for price and quantity in
individual markets
Sugar
Carpets
House cleaning services
Microeconomics considers
topics such as
Costs of production
Demand for a product
Exchange rates
Macroeconomics studies
the performance of national
economies and the policies
that governments use to try
to improve that performance
Inflation
Unemployment
Growth
Macroeconomics considers
Monetary policy
Deficits
Tax policy
Simultaneous Equations
Two equations, two unknowns
Solving the equations gives the values of the
variables where the two equations intersect
Value of the independent and dependent variables
are the same in each equation
Example
Two billing plans for phone service
How many Mbytes make the two plans cost the
same?
Simultaneous Equations
Plan 1
Plan 2
B = 10 + 0.04 D
B = 20 + 0.02 D
Find B and D
for point A
Simultaneous Equations
Plan 1 B = 10 + 0.04 D
Plan 2 B = 20 + 0.02 D
Subtract Plan 2 equation from
Plan 1 and solve for D
B = 10 + 0.04 D
B = 20 0.02 D
0 = 10 + 0.02 D
OR
D = 500
B = 20 + 0.02 D
B = 20 + 0.02 (500)
B = $30
HOW
Which technology?
Which resources are used?
The Market
Buyers and sellers
signal wants and costs
Resources and goods are
allocated accordingly
Interaction of supply and
demand answer the three
basic questions
Demand
A demand curve
illustrates the quantity
buyers would purchase
at each possible price
Demand curves have a
negative slope
Consumers buy less at
higher prices
Consumers buy more
at lower prices
16
(000s of pieces/day)
Law of Demand
Law of Demand
Consumers buy less of a product
as the price of the product rises
Price and quantity demanded are inversely related
Law of Demand
Cost-Benefit Principle at work
Do something if the marginal benefits are at least
as great as the marginal costs
16
(000s of pieces/day)
Horizontal
interpretation of
demand:
Given price, how much
will buyers buy?
At a price of $4, the
quantity demanded is
8,000 slices/day.
16
(000s of pieces/day)
Vertical interpretation of
demand:
Given the quantity to
be sold, what price is
the marginal consumer
willing to pay?
If 8,000 slices are sold
the marginal consumer
is willing to pay $4 per
slice.
Law of Supply
Law of Supply
Producers supply more of a product
as the price of the product rises
Price and quantity supplied are positively related
$4
$2
8
16
(000s of pieces/day)
Horizontal
interpretation of
supply:
Given price, how much
will suppliers offer?
At a price of $2,
suppliers are willing to
sell 8,000 pieces/day.
$4
$2
8
16
(000s of pieces/day)
Vertical interpretation of
supply:
Given the quantity to
be sold, what is the
opportunity cost of the
marginal seller?
If 8,000 pieces are
sold, the marginal cost
of producing the
8,000th piece is $2.
Market Equilibrium
A system is in equilibrium when there is no
tendency for it to change
The equilibrium price is the price at which the
supply and demand curves intersect
The equilibrium quantity is the quantity at
which the supply and demand curves intersect
The market equilibrium occurs when all buyers
and sellers are satisfied with their respective
quantities at the market price
At the equilibrium price, quantity supplied equals
quantity demanded
Market Equilibrium
Quantity supplied
equals quantity
demanded AND
Price is on supply
and demand curves
No tendency to
change P or Q
Buyers are on their
demand curve
Sellers are on their
supply curve
$3
D
Q
12
(000s of pieces/day)
Excess Demand
$4
D
16
(000s of pieces/day)
$2
Q
Shortage
D
Q
16
8
(000s of pieces/day)
Equilibrium
D
8 12 16
(000s of pieces/day)
$3
$2.50
$2
Equilibrium
D
8 12 16
(000s of pieces/day)
$2
$1
8 10
(000s of cans/day)
Shift in Demand
If buyers are willing to
buy more at each price,
then demand has
increased
Move the entire demand
curve to the right
Change in demand
P
$2
D
8 10
(000s of cans/day)
D'
Tennis Market
If rent for tennis court decreases, demand for tennis
balls increases
Tennis courts and tennis balls are complements
Tennis
Ball
Sales
P
S
$10
$1.40
$1.00
$7
D'
D
4
11
(00s rentals/day)
D
40
58
(millions of balls/day)
Apartments
Demand increases
D'
Price increases
Quantity increases
P'
P
Q Q'
(units/month)
Supply
of Donuts
P
S
$4
$2
8
16
(000s of pieces/day)
Shift in Supply
Supply increases when
sellers are willing to offer
more for sale at each
possible price
Supply of
P Donuts S
S'
Supply of
P Tuna
S*
$2
$2
8 9
(000s of pieces/day)
8 9
(000s of cans/day)
A change in technology
Desktop publishing and term papers
Internet distribution of products (e-commerce)
Supply of Bicycles
S'
$80
$60
S
D
Demand is constant
The price of handmade
carpets decreases to
$90,000 per carpet
Quantity increases to 50
$120
$90
S'
D
40 50
(carpets/
month)
P'
P
Q'
D'
Q
P
P'
Q'
D'
S
S'
P
P'
D
Q
Q'
P'
P
D
Q'
Price ($/bag)
S'
P'
D
D'
Q' Q
Increases
Decreases
Increases
P Depends
Q Increases
P Increases
Q Depends
Decreases
P Decreases
Q Depends
P Depends
Q Decreases
Efficiency Principle
The socially optimal quantity maximizes total
surplus for the economy from producing and
selling a good
Economic efficiency -- all goods are produced at
their socially optimal level
Equilibrium Principle
Equilibrium Principle: a market in equilibrium
leaves no unexploited opportunities for
individuals
Only when the seller pays the full cost of
production and the buyer captures the full
benefit of the good is the market outcome
socially optimal
To Equilibrium P and Q
Equilibrium is where P and Q are the same for
demand and supply
Set the two equations equal to each other (P = P)
and solve for Q (Qs = Qd = Q*)
16 2 Q* = 4 + 4 Q*
6 Q* = 12
Q* = 2
P = 4 + 4 Q*
P = $12